The Federal Reserve is finally succeeding in tightening financial conditions, more than two years after it began raising US interest rates. But its “success-at-home-pain-abroad” impact is being acutely felt across emerging markets (EMs).
Rising Treasury bond yields and a resurgent US currency have shaken EMs as investors have reassessed the creditworthiness of nations that loaded up on dollar-denominated debt. The US economy, in contrast, looks set to power ahead, with economists forecasting average annual growth of around 3% in the final three quarters of this year.
Central banks in developing economies from Argentina to Indonesia have now intervened to defend their currencies, depressing their foreign exchange reserves.
Between March 1 and April 27, Argentina sold $8bn of reserves to arrest a run on the peso. That’s nearly 15% of its total FX reserves. Since April 27, the peso has slumped to a record low, the central bank hiked interest rates to 40% and President Mauricio Macri has confirmed that Argentina is seeking a financing deal with the International Monetary Fund.
Argentina may be an extreme case, but no emerging country can afford to be complacent. According to the Institute of International Finance, more than $900bn of EM bonds come due this year.
Indonesia’s FX reserves fell by $7.1bn to $124.9bn between February and April as the central bank tried to support the rupiah. But the currency still lost 5% of its value in that three-month period.
Turkey’s reserves are down nearly $3bn since February.
As higher US rates would make it harder for EMs to get access to capital for investments, including addressing the huge infrastructure deficit in their economies, the EMS are now struggling to contain the high volatility brought about by hot money flows.
The deeper problem in EMs lies with the excessive financialisation of the global economy that has occurred since the 1990s. The resultant policy dilemmas – rising inequality, greater volatility, reduced room to manage the real economy – are seen continuing to preoccupy policymakers in the decades ahead.
Now some good news.
The Fed’s influence on global financial conditions should not be overstated, despite it being blamed five years ago for the “taper tantrum,” says chairman Jerome Powell. The EMs “should not be surprised by our actions if the economy evolves in line with expectations,” he said.
Optimists argue that most EMs are far less vulnerable than they were in 1997. Foreign currency holdings among EMs and developing economies are projected to be $144bn higher this year, according to the IMF. At the same time, inflation remains subdued in most economies. That means overall buffers are stronger today than five years ago.
The volatility brought about by Fed’s gradual tightening has underscored emerging markets’ enduring reliance on foreign capital. Sure, EMS still aren’t masters of their own destiny, but it’s high time they stopped looking over their shoulders at the Big Brother.
Here is the ultimate lesson: Without a significant home-grown investor base, supported by futuristic policy initiatives and structural reforms, emerging markets risk a return to the old boom-bust cycles of the 20th century.